1. McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Goals
Explain what an externality is and show how it affects the market outcome
Describe three methods of dealing with externalities
Define public good and explain the problem with determining the value of a public good to society
Explain how informational problems can lead to market failure
Discuss five reasons why a government’s solution to a market failure could worsen the situation
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3. Market Failures
A market failure is a situation in which the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes
Externalities
Public goods
Imperfect information
Government failures are when the government intervention actually makes the situation worse
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4. Externalities
Externalities are the effects of a decision on a third party that are not taken into account by the decision-maker
Negative externalities occur when the effects are detrimental to others
Ex. Second-hand smoke and carbon monoxide emissions
Positive externalities occur when the effects are beneficial to others
Ex. Education
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5. A Negative Externality Example
When there are negative externalities, the marginal social cost differs from the marginal private cost
The marginal social cost includes the marginal private costs of production plus the cost of negative externalities associated with that production
It includes all the marginal costs that society bears
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6. A Negative Externality Example
Cost, P
If there are no externalities, P0Q0 is the equilibrium
S1 = Marginal Social Cost
If there are externalities, the marginal social cost differs from the marginal private cost, and P0 is too low and Q0 is too high to maximize social welfare
S0 = Marginal Private Cost P1
Cost of externality P0
D = Marginal Social Benefit
Government intervention may be necessary to reduce production Q Q1 Q0
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7. A Positive Externality Example
When there are positive externalities, the marginal social benefit differs from the marginal private benefit
The marginal social benefit includes the marginal private benefit of consumption plus the benefits of positive externalities resulting from consuming that good
It includes all the marginal benefits that society receives
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8. A Positive Externality Example
Cost, P
If there are no externalities, P0Q0 is the equilibrium
If there are externalities, the marginal social benefit differs from the marginal private benefit, and both P0 and Q0 are too low to maximize social welfare
S = Marginal Private Cost P1
Benefit of externality P0
D1 = Marginal Social Benefit
D0 = Marginal Private Benefit
Government intervention may be necessary to increase consumption Q Q0 Q1
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9. Methods of Dealing with Externalities
Direct regulation is when the government directly limits the amount of a good people are allowed to use
Incentive policies
Tax incentives are programs using a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends
Market incentives are plans requiring market participants to certify that they have reduced total consumption by a certain amount
Voluntary solutions
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10. Tax Incentive Policies
A tax on pollution that equals the social cost of the negative externality will cause individuals to reduce the quantity of the pollution causing activity to the socially optimal level Q1
Cost, P
S1 = Marginal Social Cost
S0 = Marginal Private Cost P1
Efficient tax P0
Effluent fees are charges imposed by governments on the level of pollution created
D = Marginal Social Benefit Q Q1 Q0
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11. Market Incentive Policies
A market incentive plan is similar to direct regulation in that the amount of the good consumed is reduced
A market incentive plan differs from direct regulation because individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others
Incentive policies are more efficient than direct regulatory policies
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12. Voluntary Reductions
Voluntary reductions allow individuals to choose whether to follow what is socially optimal or what is privately optimal
The socially conscious will often become discouraged and quit contributing when they believe a large number of people are free riding
Free rider problem is individuals’ unwillingness to share the cost of a public good
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13. The Optimal Policy
An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy
Resources are being wasted if a policy isn’t optimal
For example, the optimal level of pollution is not zero pollution, but the amount where the marginal benefit of reducing pollution equals the marginal cost
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14. Public Goods A public good is nonexclusive and nonrival
Nonexclusive: no one can be excluded from its benefits
Nonrival: consumption by one does not preclude consumption by others
Many goods provided by the government have public good aspects to them
There are no pure public goods; national defense is the closest example
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15. Public Goods
A private good is only supplied to the individual who bought it
Once a pure public good is supplied to one individual, it is simultaneously supplied to all
In the case of a public good, the social benefit of a public good (its demand curve) is the sum of the individual benefits (value on the vertical axis)
To create market demand,
private goods: sum demand curves horizontally
public goods: sum demand curves vertically
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16. The Market Value of a Public Good
Price
A public good is enjoyed by many people without diminishing in value
$1.20
$1.10
$1.00
Individual A’s demand is vertically summed with…
$0.80
$0.60
Individual B’s demand
to equal…
Market Demand
$0.40
Demand B
$0.60
$0.50
Market demand for a public good
$0.20
Demand A
Quantity 1 2 3
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17. Excludability and the Costs of Pricing
The public/private good differentiation is seldom clear-cut
Some economists prefer to classify goods according to their degree of rivalry and excludability
Degree of Rivalry in Consumption
Rival
NonRival
100%
Apple
Encoded radio
broadcast 0%
Fish in ocean
General R&D
Degree of Excludability
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18. Informational Problems
Perfectly competitive markets assume perfect information
In the real world, buyers and sellers do not usually have equal information, and imperfect information can be a cause of a market failure
An adverse selection problem is a problem that occurs when buyers and sellers have different amounts of information about the good for sale
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19. Informational Problems
Signaling may offset information problems
Signaling refers to an action taken by an informed party that reveals information to an uninformed party that offsets the false signal that caused the adverse selection in the first place
Selling a used car may provide a false signal to the buyer that the car is a lemon
The false signal can be offset by a warranty
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20. Policies to Deal with Informational Problems
Regulate the market and see that individuals provide the correct information
License individuals in the market and require them to provide full information about the good being sold
Allow markets to develop to provide information that people need and will buy
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21. Policies to Deal with Informational Problems
Application: Licensing of Doctors
Medical care is an example of imperfect information, patients usually don’t have a way of knowing if a doctor is capable
Current practice is to require medical licenses to establish a minimum level of competency
Another option is to provide the public with information on:
Grades in medical school
Success rate for various procedures
Charges and fees
References
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22. Government Failures and Market Failures
All real-world markets in some way fail
Market failures should not automatically call for government intervention because governments fail, too
Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse
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23. Reasons for Government Failures
Government doesn’t have an incentive to correct the problem
Government doesn’t have enough information to deal with the problem
Intervention in markets is almost always more complicated than it initially seems
The bureaucratic nature of government intervention does not allow fine-tuning
Government intervention leads to more government intervention
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24. Chapter Summary
Three sources of market failure are externalities, public goods, and imperfect information
An externality is the effect of a decision on a third party that is not taken into account by the decision maker
Positive externalities provide third-party benefits and markets for these goods produce too little for too great a price
Negative externalities impose third-party costs, and markets produce too much for too low a price
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25. Chapter Summary
Economists generally prefer incentive-based programs, such as a tax on the producer of a good with a negative externality, because incentive-based programs are more efficient than direct regulation or voluntary solutions
Voluntary solutions are difficult to maintain because people have an incentive to be free riders
An optimal policy is one in which the marginal benefit of the undertaking equals its marginal cost
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26. Chapter Summary Public goods are nonexclusive and nonrival
Theoretically the market value of a public good can be calculated by summing the value that each individual places on every quantity
Adverse selection occurs when buyers or sellers withhold information causing the market for the good to disappear
Licensure and full disclosure are solutions to the information problem
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27. Chapter Summary
Government failure, in which intervention worsens the problem, occurs because:
Governments don’t have incentives and/or information to correct the problem
Intervention is more complicated than it initially seems
The bureaucratic nature of government precludes fine-tuning
Government intervention leads to more government intervention
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28. Preview of Chapter 22: Behavioral Economics and Modern Economic Policy
Define mechanism design and summarize its relationship to behavioral economics
Define nudge and choice architecture and explain how they are related to behavioral economic policy
Explain why a nudge policy meets a libertarian paternalism criterion
Describe three types of choices where nudges can be useful
State two types of nudge policy
Distinguish between nudge and push policies
Discuss the concerns many traditional economists have about nudge and push policies
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